Friday, August 17, 2007
the worst case scenario
Central banks are likely to attempt to ratify current inflated asset values by inflating prices and incomes to avoid a deflationary economic collapse. Unfortunately, sharp reductions in interest rates in the US, UK and the euro area will lead to a rapid unwinding of the global carry trade, perversely threatening to worsen problems in the credit markets.
The solution would have to involve massive unsterilised intervention by the Japanese authorities, which would have the effect of inflating Japanese prices to a level consistent with the current yen exchange rate, thereby alleviating huge upward pressure on the yen as the carry trade unwinds.
Combined with a similar inflation in the US this "solution" would require roughly a doubling of the Japanese price level, destroying the real value of Japanese savings.
If the losses are to manifest purely in real terms - via inflation - then they must occur mostly where the savings have been, which is certainly not in the US.
If the Japanese authorities baulk at the prospect of such a huge inflation, then global deflationary collapse will be inevitable once the credit bubble bursts.
part of that inflation will probably involve a government-backed bailout.
i personally doubt the japanese monetary authorities will balk at some very radical inflationary policies (ie, throwing money from helicopters) if america desires them to be implemented. but even if they do, the path is frought with uncertainty and the prospect for unintended consequences.